The Effect of Transaction Pricing on the Adoption of Electronic Payments

The Effect of Transaction Pricing on the Adoption of Electronic Payments: A Cross-Country Comparison.∗ Wilko Bolt†,DavidHumphrey‡, Roland Uittenbogaard§ October 2005 Abstract Pricing should speed up the substitution of low cost electronic payments for expensive paper-based transactions and cash. But by how much? Norway has explicitly priced individual payment transactions and rapidly shifted to electronic payments while the Netherlands has experienced the same shift without direct pricing. Controlling for differences between countries, we estimate the incremental effect of pricing on the shift to electronic payments. If users strongly value the improved convenience or security of electronic payments, pricing —viewed negatively by most consumers— may not be necessary to ensure rapid adoption of electronic payments. (92 words) Keywords: electronic payments, transaction pricing, demand elasticity, social benefits JEL Code: D12, G21 ∗Theviewsexpressedinthisarticlearethoseoftheauthors alone and do not necessarily represent those of De Nederlandsche Bank, or the European System of Central Banks. †Wilko Bolt is senior economist in the Research Division at the De Nederlandsche Bank, Amsterdam, The Netherlands, email: [email protected] ‡David Humphrey is professor of finance at Florida State University, Tallahassee, FL, U.S.A., email: [email protected] §Roland Uittenbogaard is economist in the Payments Policy Division at De Nederlandsche Bank, Am- sterdam, The Netherlands, and is currently employed by the European Commission in Brussels, email: [email protected] 1 Introduction. The production of electronic payments by banks typically cost from one-third to one-half as much as its paper-based equivalent or cash (c.f., Humphrey, Willesson, Bergendahl, and Lindblom, 2004). As well, merchants’ cost of accepting electronic payments over giro net- works and at the point of sale are also lower (credit cards excepted). Since the resource cost of a country’s payments system may account for 2% to 3% of its GDP, it is clear that shifting from paper to electronic payments can confer social benefits. Importantly, the discounted value of these benefits will be larger the more rapidly this shift occurs. There is overwhelming evidence that consumers respond to price incentives but almost no evidence of what this response may be in the payments area. Although consumers are used to responding to price incentives, they tend not to welcome the opportunity to trade off perceived payment preferences with relative prices when their payment use has commonly been viewed as being “free”. While businesses typically pay directly for the payment services they use via explicit transaction fees or compensating balances, consumers have traditionally paid implicitly through lost float or lower (or no) interest on transaction balances. In addition, due to competitive reasons, banks fear a loss of deposit market share if they move first (and are perhaps the only one) to explicitly price consumer payment transactions while anti-trust authorities would be suspicious of industry efforts to coordinate such pricing. One country —Norway— has overcome these difficulties by coordinating only the timing of when direct pricing of consumer payments would start —not the level of prices to be charged which could in fact be zero. The quid pro quo was an elimination of banks’ practice of recouping payment costs through payment float —debiting consumer accounts prior to a value date for bill payments or delaying funds availability for credits to accounts — which made it appear that payment use was “free”. The goal was to make payment costs more explicit so consumers could match better the benefits and costs of different payment instruments, a response expected to lower the social cost of their payment system.1 Our main purpose is to determine the effect of differential transaction-based pricing of payment instruments on the adoption rate of electronic payments. This is done by compar- ing the shift to electronic payments in two countries —one that has pricing (Norway) and one that does not (Netherlands). Transaction-based prices are key since they affect consumers’ decisions about payment use whereas fixed fees are sunk costs ex post that do not vary with usage and thus have limited behavioral effects. The implied discounted social benefitthat follows from a possibly more rapid substitution of low cost for high cost payment instruments is also estimated. Data on payment instrument use for many developed countries is available annually in various Bank for International Settlements and European Central Bank documents, as well as from payment statistics by national central banks. As these time series rarely exceed 15 years, a parsimonious model specification is necessary. A comparable time series of actual payment instrument prices on a broad range of payment instruments is available only for Norway. We contrast the rapid adoption of electronic payments in Norway over 1990-2004 with the experience of the Netherlands which also rapidly adopted electronic payments but did not impose per transaction prices on consumers. By applying a system estimation to our model we are able to improve on the degrees of freedom and increase the 1 Pricing in Norway was implemented by banks individually and encouraged by the central bank. The fact that the larger banks were first to introduce explicit pricing made it easier for the other banks to follow after a lag. Bank efforts to improve the payment system have also occurred in Canada (to eliminate the float incentive to use checks), Germany (to truncate checks and collect them electronically), and the Netherlands (shifting from paper-based credit transfers to “straight-through-processed” direct debits). 2 efficiency of our estimators. If the incremental effect of direct pricing is large, holding constant other within and cross- country influences affecting the adoption of electronic payments, then the potential social benefit can also be large. This would suggest that antitrust concerns raised by possible bank coordination of the implementation of pricing (but not any coordination of the level of prices being charged) could be offset by subsequent social benefits. It would also suggest, in a revealed preference context, that consumers generally place a relatively low value on the greater convenience and security offered by electronic payments since, otherwise, pricing would not have a large separate effect on adoption rates. A final consideration, but one not discussed here, is the loss of seigniorage revenues to the government to the degree that electronic payments replace cash at the point of sale. In what follows, we show in Section 2 how the composition of payments has evolved in Norway and the Netherlands along with the levels of relative prices in Norway. Transaction prices for consumers are zero in the Netherlands.2 Our focus is on the substitution of debit cards for cash (or cash and checks) at the point of sale along with the substitution of (remote) electronic giro payments for paper-initiated giro transactions.3 In Section 3, we specify a parsimonious point of sale “country difference” model to separate the effect of pricing debit card use and ATM cash withdrawals from differences in terminal availability and real personal consumption in our two countries. A similar model relies primarily on prices for the substitution of electronic versus paper-initiated giro payments (since terminal availability is not a constraint). By using two countries we seek to effectively “hold constant” non-price attributes that can influence payment use in addition to pricing when the analysis is applied to only a single country. Our set of four equations are estimated in Section 4 in a seemingly unrelated regression framework to improve efficiency and the effect of prices on payment composition, including the implied price elasticities, are presented. Different models are estimated to judge the robustness of the price effect under alternative specifications, such as different lagged relationships, first differences, and error correction. The social benefitof pricing is illustrated in Section 5 using bank cost data and fitted logistic S-curves to payment use data for Norway and the Netherlands. A summary of our results and the public policy issues they raise are discussed in Section 6. 2 Payment Composition, Pricing, and Other Influences on Payment Instrument Use. 2.1 Payment Composition. Both Norway and the Netherlands experienced a relatively rapid change in their payment composition for point of sale and bill payment transactions over 1990-2004. Point of sale instruments are now almost solely debit cards and cash but in the early 1990s checks were also important. As seen in Table 1, the number of debit card transactions per person per year in Norway rose from 5 to 146 over our 15 year period, growing by 25% per year.4 The 2 Some fixed fees do exist in the Netherlands. Debit card users pay a flat annual average fee of 6 euro and internet banking has a one-time startup fee of around 15 euro. 3 While check and credit card transactions are included in the analysis, check transactions are only significant in the early 1990s while there are few credit card payments in either country over the whole period. 4 Oil company terminals and cards were introduced in the 1980s as a substitute for cash at gas stations. Although these terminals also accepted bank debit cards, oil company cards could not be used elsewhere and were not priced. The Norwegian payment statistics do not include oil company transactions as debit card 3 Table 1: Payment Instrument Use Per Person in Norway and the Netherlands (1990-2004) 1990 1993 1996 1999 2002 2004 Growth Rate Debit Card transactions Norway 5 16 36 71 113 146 25% Netherlands1 42444667733% ATM Cash Withdrawals Norway 14 17 22 24 23 22 3% Netherlands 8 20 26 28 30 28 9% Electronic Giro (credit transfers + direct debits) Norway 15 18 29 46 65 78 12% Netherlands 44 54 70 93 116 124 7% Paper Giro (credit transfers) Norway 53 44 52 38 24 18 -7% Netherlands343233272118-5% Source: www.dnb.nl, DNB statistics, www.norgesbank.nl, Norges Bank Annual Report on Pay- ment Systems.

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